What Is an Indirect Rollover?
An indirect rollover is a transfer of money from a tax-deferred 401(k) plan to another tax-deferred retirement account. If the rollover is direct, the money is moved directly between accounts without its owner ever touching it. In an indirect rollover, the funds are given to the employee via check for deposit to a personal account.
- The option for an indirect rollover of money between retirement accounts should be taken with caution if at all.
- The direct rollover protects your retirement funds from income taxes and penalties for that tax year.
- The indirect rollover, if not accomplished properly, can leave you owing income taxes, an early withdrawal penalty, and even an excess contributions tax.
If there is an indirect rollover, the owner must deposit the funds into the new IRA within 60 days to avoid paying income tax on the full amount, plus a hefty tax penalty.
Understanding an Indirect Rollover
A rollover of a retirement account is common when an employee changes jobs or leaves a job to start an independent business. Most of the time, the rollover is direct, in order to eliminate any risk that the individual will lose the tax-deferred status of the account and owe an early withdrawal penalty as well as income taxes.
However, the account holder does have the option of an indirect rollover. In that case, the employer generally withholds 20% of the amount that is pending transfer in order to pay the taxes due. This money is returned as a tax credit for the year when the rollover process is completed.
The indirect rollover process must be completed within 60 days if a big tax bill and a tax penalty are to be avoided.
Once the money is in the hands of the account holder, it can be used for any purpose for the full 60-day grace period. If the person then fails to deposit it in another tax-deferred account, the entire balance is subject to tax and a 10% early withdrawal penalty will be imposed, assuming that the person is under the age of 59½.
Why Use an Indirect Rollover?
Personal financial advisors and tax advisors pretty much unanimously advise their clients to always use the direct rollover option, not the indirect rollover.
The only reason to use the indirect rollover is if the account holder has some urgent use for the money, and it can be accomplished without risk within 60 days. For example, someone relocating for a new job may have large immediate expenses that will be reimbursed in time. Failing to meet the 60-day deadline is one of the most common mistakes made by first-time Roth IRA holders.
Whether there's a good reason for using the indirect option or not, the IRS has some pretty picky rules that could trip up the account holder:
- Only one indirect rollover is permitted within a 12-month period. (That means any 12-month period, not a tax year.)
- The transfer must be from one account to another account, and cannot be split among multiple accounts.
Mess up either of these rules, and you're on the hook for income tax for the entire amount withdrawn, plus the 10% early distribution tax. And, splitting the money between accounts as described above has an added penalty of its own: You'll owe a 6% excess contributions tax on one of the two accounts every single year for as long as the account exists.